One of the least understood aspects of our tax system is that forgiven debt constitutes taxable income to the debtor.  As odd as it may sound, from a tax perspective, it makes perfect sense.

When one borrows money, loan proceeds are not taxable.  That’s because the loan has to be paid back.  Seen that way, proceeds do not increase one’s wealth because of the payback obligation.

When one does not pay a loan, something different happens than originally contemplated.  The borrower suddenly acquires “wealth”, since he no longer is going to pay back.  And the Internal Revenue Code sees that as something very appropriate to tax.  It is income.  It is “phantom” income, to be sure, but income nonetheless. Therefore, a forgiven debt becomes fair game for the taxman.

In the real world, this has very real consequences.  Suppose you owe more on your house than it is worth (your loan is “upside down”) and you sell “short”.  The amount forgiven (the note balance less what the sale provided to pay off the note) is income.  Most who sell short do so because their finances no longer support a mortgage payment, and the sudden federal and state tax bill adds insult to injury.

Cancelled credit card debt, repossessed cars, business debt…any of those things can also lead to cancellation of debt income.

The creditor sends you a form 1099-C reflecting the forgiven amount, and from there, it is supposed to go right on your return.

The Mortgage Debt Relief Act of 2007 generally allowed taxpayers to exclude income from the discharge of debt on their principal residence, but only applied to debt forgiven in calendar years 2007 through 2014.  That is no longer available.

The insolvency exception….

There is an important exception to this unsavory rule.  If one is “insolvent” then the cancelled debt is not included in income.  That is huge.

How do you know if you are “insolvent”?  Simple.  You are insolvent when your total debts exceed the total fair market value of all of your assets.  Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.

The liability section is calculated immediately before the forgiveness, so it includes the forgiven debt itself, and any other debts you owe.

Remember the old formula: Assets-Liabilities=Net Worth.

If that number results in a negative number, voila! You are insolvent.  This information is provided to the IRS on Form 982, which is attached to your federal income tax return.  Publication 4681 has a worksheet to help you figure if you are insolvent.

What if you got a 1099-C for 2014, did not know about the insolvency exception, and you already filed? You can file an amended return.  If you timely filed your tax return, you can still make the election to exclude the “cancellation of debt income” by filing an amended return within 6 months of the due date of the return (excluding extensions). Write “Filed pursuant to section 301.9100-2” on the amended return and file it at the same place you filed the original return. Of course, this will likely also require you to file an amended state tax return…in this case, a very good deal.

This is a question I hear often.  So, here's a reminder for my friends who are outside of the United States: There are several types of extensions.  Some allow you an extension to file AND pay taxes, most do not. 

Automatic 2-month extension.   You are allowed an automatic 2-month extension to file your return and pay federal income tax if you are a U.S. citizen or resident alien, and on the regular due date of your return:
  • You are living outside the United States and Puerto Rico and your main place of business or post of duty is outside the United States and Puerto Rico, or

  • You are in military or naval service on duty outside the United States and Puerto Rico.

If you use a calendar year, the regular due date of your return is April 15. Even if you are allowed an extension, you will have to pay interest on any tax not paid by the regular due date of your return.

Married taxpayers.   If you file a joint return, either you or your spouse can qualify for the automatic extension. If you and your spouse file separate returns, this automatic extension applies only to the spouse who qualifies for it.

How to get the extension.   To use this automatic 2-month extension, you must attach a statement to your return explaining which of the two situations listed earlier qualified you for the extension. [ I recommend, for instance, writing "TAXPAYER RESIDING ABROAD" in red letters at the top of the return].

Automatic 6-month extension.   If you are not able to file your return by the due date, you generally can get an automatic 6-month extension of time to file (but not of time to pay). To get this automatic extension, you must file a paper Form 4868 or use IRS e-file (electronic filing). 

The form must show your properly estimated tax liability based on the information available to you.  

Previous 2-month extension.   If you cannot file your return within the automatic 2-month extension period, you generally can get an additional 4 months to file your return, for a total of 6 months. The 2-month period and the 6-month period start at the same time. You have to request the additional 4 months by the new due date allowed by the 2-month extension.

 The additional 4 months of time to file (unlike the original 2-month extension) is not an extension of time to pay. You must make an accurate estimate of your tax based on the information available to you. If you find you cannot pay the full amount due with Form 4868, you can still get the extension. You will owe interest on the unpaid amount from the original due date of the return.

You also may be charged a penalty for paying the tax late unless you have reasonable cause for not paying your tax when due. Penalties for paying the tax late are assessed from the original due date of your return, unless you qualify for the automatic 2-month extension. In that situation, penalties for paying late are assessed from the extended due date of the payment (June 15 for calendar year taxpayers).

Additional extension of time for taxpayers out of the country.   In addition to the 6-month extension, taxpayers who are out of the country can request a discretionary 2-month additional extension of time to file their returns (to December 15 for calendar year taxpayers) (this means that the IRS grants it if it feels like it.  But one can always help by establishing sufficient facts to get it granted).

To request this extension, you must send the Internal Revenue Service a letter explaining the reasons why you need the additional 2 months. Send the letter by the extended due date (October 15 for calendar year taxpayers) to the following address:

Department of the Treasury 
Internal Revenue Service Center 
Austin, TX 73301-0045

You will not receive any notification from the Internal Revenue Service unless your request is denied.

The discretionary 2-month additional extension is not available to taxpayers who have an approved extension of time to file on Form 2350, discussed next.

This is really cool! Extension of time to meet tests.   You generally cannot get an extension of more than 6 months. However, if you are outside the United States and meet certain requirements, you may be able to get a longer extension.

You can get an extension of more than 6 months to file your tax return if you need the time to meet either the bona fide residence test or the physical presence test to qualify for either the foreign earned income exclusion or the foreign housing exclusion or deduction. The tests, the exclusions, and the deduction are explained in chapter 4.

  You should request an extension if all three of the following apply.
  1. You are a U.S. citizen or resident alien.

  2. You expect to meet either the bona fide residence test or the physical presence test, but not until after your tax return is due.

  3. Your tax home is in a foreign country (or countries) throughout your period of bona fide residence or physical presence, whichever applies.

If you are granted an extension, it generally will be to 30 days beyond the date on which you can reasonably expect to qualify for an exclusion or deduction under either the bona fide residence test or the physical presence test. However, if you have moving expenses that are for services performed in 2 years, you may be granted an extension until after the end of the second year.

How to get an extension.   To obtain an extension, file Form 2350 either by giving it to a local IRS representative or other IRS employee or by mailing it to the:

Department of the Treasury 
Internal Revenue Service Center 
Austin, TX 73301-0045

You must file Form 2350 by the due date for filing your return. Generally, if both your tax home and your abode are outside the United States and Puerto Rico on the regular due date of your return and you file on a calendar year basis, the due date for filing your return is June 15.

Also, don't forget Foreign Bank Account Reports are due on or before June 30, 2015! 

Where to file returns:
With Payment:
Internal Revenue Service
P.O. Box 1303
Charlotte, NC 28201-1303

Without Payment:
Department of the  Treasury
Internal Revenue Service
Austin, TX  73301-0215
For folks who are required to file with California:

--If you are residing or traveling outside the USA on April 15, 2015, the deadline to file your tax return and pay the tax is June 15, 2015. Interest will accrue from the original due date until the date of payment. If you need additional time to file, you will be allowed a six-month extension without filing a request. To qualify for the extension, file your tax return by December 15, 2015. To avoid any late-payment penalties, pay your tax liability by June 15, 2015. When filing your tax return, write “Outside the USA on April 15, 2015” at the top of your tax return in RED INK.

The IRS is increasing its enforcement of reporting requirements for foreign financial accounts.  (Note to my friends who have accounts in U.S. possessions: Puerto Rico, U.S. Virgin Islands, Guam, American Samoa and the Commonwealth of the Northern Mariana Islands):  If you have a federal income tax return filing  requirement, you may be required to report financial accounts in U.S. possessions.  Click below for an overview about FBARs and Forms 8938....consult me if you have questions.